The Old Days Home buyer Regulated Retail Bank 1 $ Mortgage

1930s Principles Federal government guarantees deposits, to create confidence in the banking system Federal government guarantees deposits, to create confidence in the banking system In return, the banks accept federal regulations on what they can do (to prevent “moral hazard”) In return, the banks accept federal regulations on what they can do (to prevent “moral hazard”) Size of a bank is limited Size of a bank is limited 2

The Financial Crisis (a very quick view) I. The build up (1980s – 2008) II. The end of the party (Sept-Oct 2008) III. The responses (2008-present) 3

The Build-Up (1980s-2008) Deregulation of finance (“free market” ideology) Deregulation of finance (“free market” ideology) 4

Financial Deregulation Gramm-Leach Bliley replaces Glass Steagall in 1998 Gramm-Leach Bliley replaces Glass Steagall in 1998 Commodities Futures Modernization Act (1999) Commodities Futures Modernization Act (1999) Sarbanes Oxley Rule (2002) Sarbanes Oxley Rule (2002) SEC deregulation of brokers (2004) SEC deregulation of brokers (2004)

The Build-Up (1980s-2008) Deregulation of finance (“free market” ideology) Deregulation of finance (“free market” ideology) Rise of complex “financial derivatives” and “securitization” Rise of complex “financial derivatives” and “securitization” 6

Mortgage-backed Securities MBS Collateralized Debt Obligation, CDO A big bunch of mortgages (or other assets) packaged together and sold to investors 7

Originator (e.g. Countrywide) Home Buyer Investment Bank (e.g. Goldman-Sachs) Rating agency Institutionalinvestor End lenders Insurance company (e.g. AIG) Mortgage Broker Servicer(MERS) Assigns credit rating to issued MBSs and CDOs. Is paid by the issuer of the security it is rating. Creates MBSs and CDOs Gets a fee for every mortgage made! Manages the flow of interest and principal Specialized mortgage bank Mutual funds, pension funds, hedge funds… Creates Credit Default Swaps Federal Reserve, other regulatory agencies, administration, Congress Deregulates the industry

The Build-Up (1980s-2008) Deregulation of finance (“free market” ideology) Deregulation of finance (“free market” ideology) Rise of complex “financial derivatives” and “securitization” Rise of complex “financial derivatives” and “securitization” Increasing concentration of the financial industry Increasing concentration of the financial industry Increasingly close government-finance industry ties Increasingly close government-finance industry ties Enormous profits and bonuses Enormous profits and bonuses Praised by many economists as healthy, contributing to stability, etc. Praised by many economists as healthy, contributing to stability, etc. 9

Problems Sub-prime loans (predatory lending) fuels housing bubble Sub-prime loans (predatory lending) fuels housing bubble 11

Originator (e.g. Countrywide) Home Buyer Investment Bank (e.g. Goldman-Sachs) Rating agency Institutionalinvestor End lenders Insurance company (e.g. AIG) Mortgage Broker Servicer(MERS) Assigns credit rating to issued MBSs and CDOs. Is paid by the issuer of the security it is rating. Creates MBSs and CDOs Gets a fee for every mortgage made! Manages the flow of interest and principal Specialized mortgage bank Mutual funds, pension funds, hedge funds… Creates Credit Default Swaps Federal Reserve, other regulatory agencies, administration, Congress Deregulates the industry

Housing Price Bubble

Problems Sub-prime loans (predatory lending) fuels housing bubble Sub-prime loans (predatory lending) fuels housing bubble Rating agencies give CDOs AAA ratings Rating agencies give CDOs AAA ratings 14

Originator (e.g. Countrywide) Home Buyer Investment Bank (e.g. Goldman-Sachs) Rating agency Institutionalinvestor End lenders Insurance company (e.g. AIG) Mortgage Broker Servicer(MERS) Assigns credit rating to issued MBSs and CDOs. Is paid by the issuer of the security it is rating. Creates MBSs and CDOs Gets a fee for every mortgage made! Manages the flow of interest and principal Specialized mortgage bank Mutual funds, pension funds, hedge funds… Creates Credit Default Swaps Federal Reserve, other regulatory agencies, administration, Congress Deregulates the industry

Problems Sub-prime loans (predatory lending) fuels housing bubble Sub-prime loans (predatory lending) fuels housing bubble Rating agencies give CDOs AAA ratings Rating agencies give CDOs AAA ratings Credit default swaps become an enormous casino Credit default swaps become an enormous casino 16

Originator (e.g. Countrywide) Home Buyer Investment Bank (e.g. Goldman-Sachs) Rating agency Institutionalinvestor End lenders Insurance company (e.g. AIG) Mortgage Broker Servicer(MERS) Assigns credit rating to issued MBSs and CDOs. Is paid by the issuer of the security it is rating. Creates MBSs and CDOs Gets a fee for every mortgage made! Manages the flow of interest and principal Specialized mortgage bank Mutual funds, pension funds, hedge funds… Creates Credit Default Swaps Federal Reserve, other regulatory agencies, administration, Congress Deregulates the industry

Credit Default Swap (CDS) Like an insurance policy for CDO/MBS. Like an insurance policy for CDO/MBS. But not called “insurance,” since that would be regulated! But not called “insurance,” since that would be regulated! One doesn’t need to actually own any CDO/MBS to buy CDS, so it becomes a huge vehicle for speculation. One doesn’t need to actually own any CDO/MBS to buy CDS, so it becomes a huge vehicle for speculation. 18

The CDS Market

Problems Sub-prime loans (predatory lending) fuels housing bubble Sub-prime loans (predatory lending) fuels housing bubble Rating agencies give CDOs AAA ratings Rating agencies give CDOs AAA ratings Credit default swaps become an enormous casino Credit default swaps become an enormous casino Leaders move back and forth from Wall Street to federal government Leaders move back and forth from Wall Street to federal government 20

The End of the Party (Sept-Oct 2008) Housing prices have fallen Housing prices have fallen 21

The End of the Party Housing prices have fallen Housing prices have fallen Trillions of $ of assets evaporate Trillions of $ of assets evaporate Fannie Mae and Freddie Mac nationalized Fannie Mae and Freddie Mac nationalized Lehman Brothers goes bankrupt Lehman Brothers goes bankrupt Government bails out AIG Government bails out AIG Merrill Lynch sold Merrill Lynch sold Financial markets freeze up Financial markets freeze up Government announces TARP (Troubled Asset Relief Program) to prop up banks Government announces TARP (Troubled Asset Relief Program) to prop up banks 23

24

The Responses TARP bails out “too big to fail” investment banks (Citigroup, BofA, Goldman Sachs…) TARP bails out “too big to fail” investment banks (Citigroup, BofA, Goldman Sachs…) Recoup bonuses paid? Only talked about. Recoup bonuses paid? Only talked about. Re-regulation of banks, rating agencies, etc? Not much. Re-regulation of banks, rating agencies, etc? Not much. Criminal prosecutions? Still waiting… Criminal prosecutions? Still waiting… Help for homeowners under water? Not much. (And MERS, foreclosure mess) Help for homeowners under water? Not much. (And MERS, foreclosure mess) 25

Originator (e.g. Countrywide) Home Buyer Investment Bank (e.g. Goldman-Sachs) Rating agency Institutionalinvestor End lenders Insurance company (e.g. AIG) Mortgage Broker Servicer(MERS) Assigns credit rating to issued MBSs and CDOs. Is paid by the issuer of the security it is rating. Creates MBSs and CDOs Gets a fee for every mortgage made! Manages the flow of interest and principal Specialized mortgage bank Mutual funds, pension funds, hedge funds… Creates Credit Default Swaps Federal Reserve, other regulatory agencies, administration, Congress Deregulates the industry